Tuesday, December 30, 2008

Where the Next Bubbles Will Come From and How They Will End

One of the biggest problems with our current financial system is the fact that lower interest rates -- or the reasonable expectation of falling future interest rates -- encourages overinvestment. This inevitably leads to speculation and a subsequent asset price bubble. As Kindleberger states in his timeless "Manias, Panics, and Crashes" over trading through speculation will be followed by a "CONVULSION." Oftentimes this is some outside news factor that suddenly makes the boom model untenable.

In the case of the current crisis, the exogenous news factor was the pricking of another asset price bubble: the housing market. When ripples from the housing bust hit the banks of the world, it created a chain reaction. While our banks lost lots of money on their crappy mortgage exposure, their losses were dwarfed in magnitude by those experienced in the subsequent world stock market carnage. Some 30 TRILLION DOLLARS of wealth evaporated in 2008. But how much was made on the way up? Considering the current boom can be traced to the 1970's 30 trillion is just a drop in the bucket.

One lesson must be leaned from the thousands of years humans have used money and trade to lubricate their lives. Markets will have booms. Booms will lead to busts. But when the rate of interest is near zero percent: the urge to lever up will become too great.

Somewhere, sometime in the future, some trader at some bank will figure out that he can borrow from the fed for zero percent and lend for two percent. He will make a huge bonus and all his trader friends will do the same type of trade. The next year many traders will leave this bank and go to other banks and hedge funds. There they will tell tales of their trade, and they will borrow money at zero percent and lend money at two percent. Except when EVERYBODY does this, we will have another credit bubble.

The money lent out at 2% won't just sit in a drawer some where. It will be invested in some asset. If the speed at which money is being lent creates more money that needs to be invested than the supply of existing assets, prices will rise. But we can't use classical economics here. This is because while the supply of assets will certainly increase from bankers hocking IPO's and new bond issues, financial assets are not normal goods.

When a normal good or service rises in price, people consume less of it. When the price of a stock goes up, more people want to buy it. They see others making a killing and want a piece of their own. Likewise, when prices go down people sell more: they don't want to lose even more money. This means that credit bubbles become unstoppable reinforcing "virtuous cycles." These, of course, are followed by horrifying unrelenting market declines (vicious cycles).

Prices will stabilize. Money will be relent at too low interest rates. Money will be borrowed by firms and investors which will push up asset prices. More money will be lent. Some will go to increased demand for borrowed funds by speculators. They want to take advantage of rising prices. More money will be lent...

Monday, December 29, 2008

Oil Making a Bottom

I am in no way long. I'm not going long. This is in no way an endorsement to buy anything in this market. But I am going to call this a bottom in oil and most other commodities for at least 6 months. If i'm right: expect a huge rip off the bottom that is in no way sustainable.
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How the Stock Market Works 2: Some Simple Statistical Arbitrage

So I'm gonna attempt to explain some statistical arbitrage (or stat arb, in the truncated parlance of the street). Depending on your experience level, your reaction to this post should range from "duh" all the way through "well uhh" straight through to the "what the fu..." Its OK, you're gonna make it, I promise. Just stick with it and you will come out a smarter person on the other side.

In finance, there are many assets which seem to be driven by the same process. The fate of a collection of oil companies will rise and fall with the price of oil. A parent company may make record profits only if its partially owned subsidiary company gets a new contract. Or it could be something as simple as company A owns a 20% stake in company B. For whatever reason, there are plenty of examples of how the price of two seemingly different assets are linked together. When an educated investor sees two stocks moving together, he should know that there is an opportunity for profit.

Asset prices that move in concert are known as "cointegrated." Although this term has a technical definition, the intuition is straightforward. If the price of an asset rises, we would expect the price of its cointegrated partners to be rising as well. If prices are not moving together, it is because of some temporary anomaly. Thus an investor can profit by buying one cointegrated asset and selling another.

In particular, suppose we have two related assets- A and B- and we observe A rising and B falling. The arbitrageur can then sell A and buy B. Now he has a "market-neutral" position. Theoretically he does not care what direction the market as a whole takes because he is both long and short.

The investor above is betting only that the spread between the two cointegrated assets will narrow (long and short at the same time is known as a spread) . This will occur if A decreases more than B decreases or if A increases less than B increases.

For example, suppose we're long 100 shares of B and short 100 shares of A. If the market increases, its likely that our two stocks will also increase. We will make profit if the money we make in one side of the spread is more than we're losing on the other. If A rises 2 points and B rises 2.5 points, we will have lost 200 on the short position and made 250 on the long position, netting out to a profit of 50 dollars. Else, if A rose 3 points, we would lose 50 dollars.

It is important to note that a trader can make a spread out of any two assets. You could go long gold and short gasoline for example. But it is the idea of cointegration that makes the above spread so powerful. If two assets are truly related, then the spread will eventually narrow, netting the stat arb a profit.

The risks are twofold. The first is that the spread will increase so much in the short term as to bankrupt the arbitrageur before the relationship returns to normal. This is a very real risk, especially if leverage is involved. The second risk is that the relationship will cease to exist. Perhaps company A dumped its holdings of company B. Maybe company A had a corrupt CEO who embezzled billions and takes the equity to zero overnight. Either way, the fortunes of the two companies could diverge quite strikingly.

On the whole, the cointegration trading described above is useful only for calm and stable markets. But risk profiles can be adjusted for any market. In a benign market, this strategy would seek small but frequent intraday returns. The stat arb would thus make alot of trades to capitalize off of low volatility in the size of the spread itself. In a crazy market like we have now, the number of trades would be cut down dramatically. Spreads have gotten very volatile, and opposing small moves could send one to the poorhouse. Waiting for spreads to widen significantly is the only way to implement this strategy in a high volatility marketplace.
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Saturday, December 27, 2008

What the Data Can't Tell You: Plucking the string of the market

Price-Earnings Ratios as a Predictor of Ten-Ye...Image via Wikipedia
So much time and effort has been placed in the pursuit of analyzing past stock market data sets to mine for statistically significant anomalies. This is a great process for determining what would have made you money in the past, but is lousy for predicting how the strategy will perform when large amounts of money are employed to capture the discovered anomaly. Oftentimes, especially in statistical arbitrage, the presence of one or two more large players can tip a once profitable strategy into a money pit.

The key to arbitrage is being the first or second to find it... and staying small. Scaling up a strategy is hard, but making small amounts of sure money is easy for those patient enough. Perfecting a stable of small but consistently profitable arbitrage strategies is the key to long term income.

A successful arbitrageur should be able to be both statistician and wildcatter. We must pluck the string of whatever market instrument we have assembled and listen to what sound results. We must model the interaction of our strategies with the market as judiciously as we derive the theoretical arbitrage itself. Otherwise, taking a strategy from theory to practice is impractical and useless.

This financial crisis has taught that even the most statistically inclined of us must have a sense of just going with the flow. Make a decision. See what happens. Go from there. Use the tools that have worked before but with new assumptions.
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Friday, December 26, 2008

How the Stock Market Works 1: The Opening Liquidity Premium

There is the most trading volume per second during the first and last thirty minutes than during any other point in the day. This means that if you are a fund manager, or large investor, or whale you want to buy/sell during the opening or closing of the market in order to maximize the amount of your inventory that you can accumulate/liquidate.

For example: assume that during 9:30-10:00am you could sell 5 million shares while depressing the market two dollars. During 10:00-10:30 that 5 million would move the stock 10 points. When do you want to sell it? Exactly: during the open. Since you can buy/sell more off the open, price becomes a non-factor. Moving stocks up or down a few percent is a function of how much size people have to accumulate (buy) or distribute (sell) at any given moment.

Since the open and close represent the greatest opportunity for large shareholders to enter and exit quickly, you will always see large orders towards the opening and close of the market.

The Social Networking Bubble

Bubbles can come in many forms. In the 1600's the dutch pushed the price of tulips to levels that were not justified economically at the time. One could have exchanged several oxen and a wagonload full of a year's worth of food for some moderately desired varieties of the high tulips. Whats more, supply constraints could not explain it.

The common and widely available tulips exploded in value as well. They were traded by the lower classes and even had options written on them for forward delivery. If the 17th century dutch had google back then, I would be willing to bet more than a few guilders that the search term "tulip" would garner a result like the one above in google trends.

I am frightened that we're in a social networking
bubble. Some of the corpses are already floating to the surface. myspace has faltered, something i don't have a compelling explanation for at the moment.

since microsoft's historic investment, much focus has shifted to facebook. One only has to glance at the charts below to see the danger that a pricking of the social networking bubble could bring.

Anecdotal evidence points to a different story for your average social networker now has the easiest time in history finding new friends and exchanging ideas. The philosophy that has inflated the bubble was always very compelling .

But relying on a network that thrives on people adding their own media content is bound to garner more than one was bargaining for. Just look at the successive waves of negative responses that the facebook management fields after each update to its mainpage.

One thing is clear. At current search levels, if facebook were to go public, I am buying.

Wednesday, December 24, 2008


not that i'm predicting the end of the world but i feel the need to comment on the absolute VACUUM of market commentary predicting a huge decline next year. i haven't seen anyone say that they think there's another 50% decline in the market next year. where are the crack pots? everyone on cnbc is non directional or at least vague as shiiiii.

ever being the contrarian, shouldn't the market gravitate towards the thing everybody fears but no one will say? i see so much "this one will be different than before" on the upside and even now during a decline. japan has been f%$#ed for years. the great depression lasted for 10+. there were several recessions referred to as depressions in the 1800's. the most notable being after the western blizzard of 1857, initiated by the huge gold discoveries in 1849 onward, which created a HUGE MOTHER F%$#ING CREDIT BUBBLE. it just all sounds so familiar.

the governments of the world discovered a huge new pile of gold in the form of export-saving economies financing import-spending economies. asia financed america's spending binge by loaning us all the cash we just sent over through intermediaries like wal-mart and target. this gigantic ponzi scheme touched off a gigantic credit bubble that sent house prices (and the price of everything else) soaring.

now we're in the pricking of the bubble phase. where did people like this get off saying that we would have a large recovery in six months. now this is the mantra of every commentator out there. i have since realized that mine was based more on a hope and a song than rational thought, and have thusly revised my M.O.

I now realize that we are on the cusp of something great. obama refered to it as the arc of history... right now it is more like a pin head. On the downside is the great financial "demon" of deflation. this would destroy our current world economy, but would rebalance them for the long term better. short term interests (the current world order) do not want this to happen, and will fight tooth and nail to maintain inflation. they very well might, but they will systematically devalue the dollar to do so.

on the upside is another huge credit fueled bubble like the ones we've seen in the past. then the inevitable bust and a further retesting of our trajectory on the needle point of history.

historic volatility has certainly increased. build a bunker.

Tuesday, December 23, 2008

Sorry for the Absence

First of all I would like to allay fears that my buy the dips mentality has put me asunder. I mean, it would have, had I continued to follow a V-shaped recovery hypothesis that failed to materialize. As the crisis unfolded, it became clear that we were at the beginning of a prolonged period of economic change. As such, some serious revamping of my strategies was in order.

My personal trading has gone from directional to completely market neutral. I am no longer trying to make money on the market going in a particular direction. The market is sh#! and may remain so for much longer than expected. Thus arbitrage strategies (and the sure but small profit) take precedence over killing it on one side of the market.

I would not abandon the buy on the dips philosophy entirely. As this website points out, the traditional public sentiment indicator seems to be alive and well. This states that when the public is rushing to one particular side of the market, a smart trader had best be taking the opposite side of their trade. This chart shows that one could have used the google search traffic for the term "stock market" to time each major bottom we have experienced since Feb 2007. Pretty amazing to see it in action.

Sorry again for the disappearing act. My goal is to continue to provide quality content at a more reasonable pace. Keep it posted. Happy Holidays. Here's to a better 2009 for everyone!